Despite sell-off, Penney's has the lead into holiday

Good news for J.C. Penney shares earlier the week set investors up for a disappointment Friday.

The department store capped off a brutal week for retail earnings. Penney's stock fell nearly 15 percent in early trading, despite posting a third-quarter loss of 45 cents a share, narrower than Wall Street estimates and a 27 percent improvement compared with the prior-year period.

But the retailer had seen gains earlier in the week, after it pre-announced same-store sales results that outperformed competitors. Penney's showed it wasn't immune from a broad retail sell-off, with the S&P Retail exchange dipping roughly 3 percent Friday, led lower by a 18 percent decline from high-end department store Nordstrom.

Citi analyst Paul Lejuez attributed Penney's weakness to "generally high expectations" for the stock heading into its announcement, and concerns about fourth-quarter performance. The decline came a series of disappointing earnings results sent shock waves through the investment community, which had already been bracing for a lackluster holiday season.

But while Penney's still has a long way to go in reaching its goal of $1.2 billion in EBITDA by 2017, it continued to show marked progress in its turnaround efforts during the quarter, despite broad under performance by its competitors. Comparable sales continued their upward trend, increasing 6.4 percent. Meanwhile, the company's gross margin once again ticked higher, as it increased the level of private-brand products in its stores and several of its merchandising initiatives took hold.

To be sure, Penney's is working off a significantly lower base than its competitive set, after a failed turnaround attempt eroded its market share. But it's nonetheless succeeding in recapturing a piece of consumers' wallets.

"Growth at both total and same-store level has improved significantly since the last quarter, with consequent uplifts to the profit line," said Hakon Helgesen, an analyst at retail research firm Conlumino. "While J.C. Penney remains loss making, the scale of that loss is much less severe than it used to be, and continues to move in the right direction."

Looking to the fourth quarter and beyond, CEO Marvin Ellison, who officially took the reins from Mike Ullman in August, outlined a number of opportunities for the retailer to continue growing its top and bottom lines during the critical fourth quarter and beyond despite a difficult consumer environment that sent retail stocks reeling.

For one, the company is placing a big bet on inventories, which are up 9.3 percent over the past year. While Ellison candidly said that increase could be viewed as a risky move — particularly as competitors including Macy's have pointed to an inundation of product as a markdown risk during the holiday period — he told investors that the investment is necessary for Penney's as it grows sales in the mid-single digits.

Last year, Ellison said, he heard "overwhelmingly" and "saw with my own eyes" that the retailer was out of stock in key categories including sheets, towels, underwear and boots. So when shoppers came into Penney's stores, they were unable to convert that traffic into sales.

He quantified that 40 percent of the inventory build is related to basic merchandise, which has no seasonality and therefore little to no markdown risk. Other factors include sales growth both in-stores and online.

"We feel very good about the levels and content of our inventory," the company said.

Victor J. Blue | Bloomberg | Getty Images

Customers browse the make-up area at a Sephora USA store inside a J.C. Penney store in Brooklyn, New York.

J.C. Penney has also identified its partnership with Sephora, and the opportunity to get those beauty shoppers to visit other departments in the store, as key. So far this year, Penney's has opened 28 additional Sephora shops, bringing the total to 519. Ellison said the company will accelerate such openings next year, and will provide more details at the end of the fourth quarter.

The company is also revamping the area adjacent to its Sephora shops in roughly one-third of its stores, saying the pilot results have led to significant sales improvements in fashion jewelry, handbags and accessories.

Ellison added that its decision to rebrand its salon business as InStyle has brought in new customers, as it's been able to better recruit better stylists who bring their clients along with them.

But just because J.C. Penney has made strides does not mean it isn't facing the same headwinds as its competitors in the department store space. These include a shift to online shopping, an area in which Penney's is investing but still lags. It's also selling to a consumer base that prefers to spend on experiences like dining out, and who have seen stagnant wage growth.

Even Nordstrom, which caters to a higher-income consumer, missed expectations during the quarter and lowered its full-year guidance, saying it simply had fewer shoppers in its stores during the period.

"Traditional consumer bears might view this sudden volatility as the early indication of larger macro issues with the U.S. consumer," Evercore ISI analyst Omar Saad wrote in a note to investors. "But we firmly believe the confusing disconnect between the seemingly strong health of the high-end U.S. consumer on paper ... and actual retailer results is much more a reflection of the tectonic shifts across the retail landscape."